Define: Current Exposure Method

The Current Exposure Method (CEM) is a risk assessment technique used in financial institutions to calculate the potential loss that may arise from the default of a counterparty in derivative transactions.

CEM calculates the current exposure by considering the market value of the derivative contract, potential future exposure, and the credit risk associated with the counterparty. It takes into account factors such as the type of derivative, collateral, and netting agreements.

CEM helps financial institutions assess and manage their credit risk exposure in derivative transactions. It provides a measure of the potential loss that may occur if a counterparty defaults, allowing institutions to allocate appropriate capital and manage their risk exposure effectively.

The use of CEM is not mandatory, but it is widely adopted by financial institutions as a best practice for measuring and managing credit risk in derivative transactions. Regulatory authorities often encourage its use as part of their risk management guidelines.

CEM can be applied to a wide range of derivative transactions, including interest rate swaps, credit default swaps, foreign exchange contracts, and equity derivatives. However, its applicability may vary depending on the specific characteristics of the transaction.

CEM takes into account the impact of collateral and netting agreements on the potential exposure. Collateral received or posted by the parties can reduce the credit risk exposure, while netting agreements allow for the offsetting of positive and negative exposures between different derivative contracts.

CEM is primarily designed for derivative transactions, as it focuses on measuring credit risk arising from counterparty default in these specific contracts. For non-derivative transactions, other risk assessment methods may be more appropriate.

CEM relies on various assumptions and models, which may introduce some degree of uncertainty and potential inaccuracies. Additionally, it may not capture all aspects of credit risk, such as systemic risks or market-wide events.

Financial institutions should regularly review and update their CEM calculations to reflect changes in market conditions, counterparty credit ratings, collateral values, and other relevant factors. The frequency of updates may vary depending on the institution’s risk management policies and regulatory requirements.